Emerging Markets Oil Industry-Fixed Income

It is time to reconsider EM oil credits. Oil prices have declined substantially during the end of 2018 and many investors may start remembering the commodity crisis of 2014 and 2015; nonetheless, the note has the intention to give comfort and explain that the current conditions are different. Furthermore, it may prove that investing in EM oil credits could be an interesting proposal in the short term and a defensive strategy in the long run. It is worth reminding that the EM market due to its relatively underdeveloped nature will have a strong correlation with the evolution of the commodity complex and many sell side strategists argue that oil may be the most defensive play in such universe and only another few such as aluminum or coffee may perform as good as oil. Finally, most of the EM oil names are SOEs with a government backing them and relatively good liquidity due to their size in the EM credit market.

Brent Prices / Commodity Forecasts and Forward Curves

Source: Bloomberg

Oil Industry Perspectives

Supply and demand conditions for 2019

According to GS (Goldman Sachs), the current oil price is pricing a growth demand of only 0.9 mb/d for year 2019 that translates to a 2.5% global GDP growth. From the supply side for 2019 there could be a recovery in oil prices in the 1H19 due to the OPEC supply cuts, decreasing US oil Capex and end of the Iranian waiver. From the demand side prices should be supported by a relatively strong demand with respect expectations. Nonetheless, such rosy scenario should be taken carefully because in the 2H19 we may see a different picture. Surplus in the 2H19 may start picking up especially once new pipelines in the US are able to deliver low cost Permian oil. Furthermore, current high inventory levels, increased Permian off take capacity (increasing drilling capabilities from US majors), increased low cost production capacity from OPEC and Russia, ramp up of projects in Brazil and Canada should be additional variables from the supply side to take into account for the 2H19. Therefore we may only see a recovery of oil prices during the 1H19 and then they should start adjusting by the 2H19. Currently the oil forward curve is slightly contango (actually mostly flat); however; it may go back to backwardation in the following months due to oil fundamentals and producers aiming to hedge their long term positions.

The oil (and commodity) rout that started in 2014 and it had a strong impact not only in the real economy but also in the markets. As we may see in the following graph and taking the oil price evolution, oil price were declining all through the 2H14 but it was not until the end of 2014 when the market started to realize that the fundamentals of the oil industry had changed and no one had a clear picture of the future. Thereby, it was not until the end of 2014 that the oil price contraction started to have its toll in the fixed income markets and credit spreads started to be more beta sensitive. It was until the beginning of 2016 that oil prices found their climax and fixed income markets also found their peak. The new balance was achieved through adjustments from both the demand (GDP growth) and the supply side (company defaults, Capex cuts, close of inefficient fields etc).

Oil in general seems to be relatively more favored in the short term than other commodity plays (metals and agricultural goods). Oil prices are poised for a short term recovery due to a better scenario than expected from the demand side (economic growth); however, in the long term there are some headwinds from both the supply and demand side that may prove to be a constraint for a bullish case. Nonetheless, in emerging market most of the oil companies are SOEs and their dynamic tend to differ from IOCs (independent oil companies). Moreover, when analyzing SOEs, the strength of the sovereign and the structural interdependence are variables that should be taken into account. Thereby, a common mistake of the investment industry is recommending SOEs as isolated entities. Both IOCs and SOEs have learned from the past and they are better prepared for the current scenario than 4 or 5 years ago. Finally, by market size, most of these SOEs are important players in the EM credit scene and provide better liquidity and depth than many other credit peers.

In the case of EM Oil credits, companies have done their job during the last years, they have been able to reduce substantially their exploration and lifting costs, renegotiate their debt under more convenient and realistic conditions, in many cases they have reduced leverage, hedging their sales and rationalizing both CAPEX and working capital. For most of the EM companies, the most effective and fast way to cope with the oil crisis was slashing CAPEX; however, such measure had a toll in reserves. Therefore, nowadays with much cleaner balance sheets, Companies are no longer in survival mode and most of their efforts are in the discovery and developments of reserves, and upgrading refineries.